Suffering Under Improper Banking Practices and Government Monetary Laws

Improper Means of Exchange

There are many ways in which human beings have created means of exchange (currency, means of payment, money) that have worked successfully over long periods of time. There is the way that Menger explained, through discovery of a highly marketable commodity. This is the way in which precious metals gained ascendancy. Another way is through banks that have intermediated short-term (90-day) bills of exchange and provided bank notes. This was common for many centuries. Another way is through the deposits of goldsmiths at a bank in exchange for certificates that circulate. Fourth, governments have created tax certificates good for paying taxes, and these have functioned as means of exchange. We should not forget also that there have been many commodities that have been used as means of exchange.

This is not an exhaustive list. It is enough to suggest that the private economy is perfectly capable of generating a variety of means of exchange that solve the economic challenge of low-cost exchange without barter. It is also enough to suggest that even a government can devise a legitimate means of exchange without imposing an illegitimate forced currency, that is, legal tender.

None of these listed methods can cause an economy to malfunction, properly used. None can cause unemployment, properly used. None of them ever has, not unless banks or governments broke certain rules that fundamentally changed the means of exchange into something illegitimate or improper or not fitted to the purpose and to the economizing behavior of human beings.

I have particularly in mind such improper acts as the following:

Governments taxing freely-developed means of exchange so as to disadvantage them.

Governments forcing citizens to use a currency by legal tender restrictions.

Banks issuing notes against assets that were not short-term or were not liquid, assets such as term loans, real estate, stocks and mortgages.

Banks using financial leverage, usually excessive, to borrow money to buy illiquid and/or long-term assets and mixing this activity with the issuance of notes against short-term self-liquidating bills.

Banks rolling over short-term bills and improperly converting them into longer-term obligations.

Governments making their own bonds the basis of issuing bank notes.

Governments insuring bank deposits when the banks were using the funds to buy long-term and/or illiquid assets.

Governments setting up central banks with special privileges such as making their notes legal tender.

Central banks with the power to bail out illiquid banks and other financial institutions that have purchased illiquid assets and become insolvent.

Governments and central banks that favor large banks.

Central banks with the power to purchase government bonds with its government-forced means of payment.

Governments that issue certificates or bills of credit far in excess of what they can collect in taxes.

Governments that prevent or restrict their citizens from buying foreign currencies or foreign assets.

Central banks with a monopoly on note issue and the concurrent phasing out of notes issued by individual banks.

This too is not an exhaustive list.

How Improper Means of Exchange Cause Large Scale Economic Problems

Here we have the opposite situation. Every one of these improper and illegitimate activities has historically been used. Not only can they cause large economic problems, they have caused such problems.

Even prior to the Great Depression, thousands of banks failed in America. This was not because they were unit banks or undiversified, it was because they had invested in long-term illiquid assets, such as farm land and mortgages tied to farm land, whose prices declined. They declined because they had been driven up by World War I and the accompanying excessive creation of means of payment by the central bank (the Fed). During the 1920s, the Fed created funds that flowed into stocks financed by loans issued, improperly, by banks, since stocks are long-term assets. History shows again and again that banks cannot safely issue redeemable bank notes against long-term assets. Indeed, the stock market crash in 1929 triggered bank failures in America and worldwide.

The large-scale bank failures in the 1930s caused a currency famine, much as in 1893, but the banks in this case did not create a currency of clearinghouse certificates as they had in 1893. The Fed now controlled base money. The result was a large-scale deflation and depression.

With the private creation of currency by proper means and a proper system of governing law, this could not have happened.

Suffering Under Improper Banking Practices and Government Monetary Laws

When banks employ improper practices and when governments make improper laws that shape the banking industry and the entire monetary system, what are the results? We get inflation, deflation, stagflation, booms and crashes, unemployment and, very often, needless wars. We get frictions with other nations, trade interruptions, and excessive volatility of asset and commodity prices. We get resources diverted into efforts to protect against this system. We get failures in accounting. We get excessive frauds and rampant speculation. We get malinvestment. We get extremely unhealthy alliances between financial institutions and governments.

We the ordinary people get a great deal of needless suffering.

Improper practices and laws are the rule, not the exception. It is absurd to blame the 2008 crash and the subsequent deep recession and continuing economic difficulties on the free market or on capitalism. When it comes to the monetary system, these are nowhere in sight.

The current financial system issues that surfaced with a vengeance in 2007-2008 and have not yet been resolved are no different from any others in the past in the sense that the causes of them are the same as always: improper banking practices and improper government laws shaping financial institutions and the monetary system.

Major banks and investment banks borrowed short and lent long. They bought long-term assets with short-term deposits that, under the central banking system, are treated as money or close to it. They broke the economic rule that banks should only properly invest such deposits in self-liquidating loans of 90 days or less while also keeping liquid reserves. They broke the other rules as well. The long-term assets were and are related to the housing industry, in which prices were inflated both by the Fed’s easy money and government encouragement in various ways. When those assets fell in price, the dominoes began to fall. By providing loans and creating huge amounts of base money, the Fed prevented widespread failures of these fundamentally flawed and mismanaged institutions that are working within a fundamentally flawed government-created system of laws and regulations.

The Fed postponed fixing the system, but this simply continues and worsens the suffering. The basic problems and issues have not been resolved in the intervening 4 years. They have literally been papered over or, more accurately, digitized over. The system is now operating in “pretend” mode. In some countries in Europe, pretending is no longer possible.